What does allowing banks to co-originate loans with NBFCs mean and how does it help?

The intimate and inextricable linkage between banks and NBFCs has been an old story. In most rural areas, the banks do not have the spread, reach or the wherewithal to deliver loans to the small business and agricultural sector. That is the gap being currently filled up by the NBFCs and the Micro Finance Institutions (MFI). In other words, the banks lend to the NBFCS and these NBFCs on-lend to the rural and small scale sector. This has been the model for quite some time. It suits both the ends of the picture. The bank gets an incomparable network that may cost a lot to set up and also monitoring may not be possible in its current structure. For the NBFCs, they get funding from the banks that anyways need to meet their 40% priority sector lending target for the year. Now RBI wants to give credence to this business model by permitting banks and NBFCs to co-originate loans. In other words, there will be sharing of responsibility and a sharing of risk. It will not just be capital support from the banks but full involvement too. Let us understand this co-origination and its implications in more elaborate detail.

Why did the RBI permit co-origination?

The permission has just been given and it is hoped that this complete system should be up and running ideally by the end of September. Under the new RBI guidelines, all scheduled commercial banks (SCBs) will be allowed to co-originate loans with Non-Banking Financial Companies (NBFCs) for creating eligible priority sector assets. As you are aware, banks are required to lend 40% of their loan book to the priority sector which predominantly includes agriculture, rural demand, small scale businesses etc. Priority sector loans include loans given to the agriculture sector (farm credit, agriculture infrastructure and ancillary activities), micro, small and medium enterprises (MSMEs), export credit, education, housing, social infrastructure, and renewable energy, among others.

The central bank, however, has excluded regional rural banks (RRBs) and small finance banks (SFBs) from co-origination as most of the loans they originate are priority sector loans. Further, only NBFCs classified as Non-Deposit Taking- Systemically Important can get into co-origination arrangements with scheduled commercial banks. The whole idea of co-origination is to have a rational and acceptable sharing of risk and rewards between the banks and the NBFCs. Such an arrangement will also bring about an alignment of objectives instead of banks looking at NBFCs as purely their last mile delivery agents. That is not helping the cause of priority lending to a great extent.

Learning from farm loan waivers

There are obviously some lessons learnt from the farm loan waivers where the liquidity crunch and the defaults led to a liquidity crisis for most NBFCS and MFIs operating in the last mile lending business. If such loans are co-originated, then there will be a more rational sharing of risks between the banks and the NBFCs. While banks will be able to bring in their fine-tuned appraisal skills to the table, the NBFCs will bring a more granular understanding the market. According to the RBI, this combination should work to the benefit of the originator and the customer in the final analysis.

In its ‘Statement on Developmental and Regulatory Policies’, which was issued along with the third bi-monthly monetary policy statement, the RBI said the guidelines on co-origination of priority sector loans would be issued by the end ofSeptember 2018. For domestic scheduled commercial banks (excluding RRBs and SFBs) and foreign banks with 20 branches and above, the RBI has set priority sector lending target at 40 per cent of Adjusted Net Bank Credit, or Credit Equivalent Amount of Off-Balance Sheet Exposure, whichever is higher. Within priority sector lending, there are sub-targets for agriculture, micro-enterprises, and advances to weaker sections. If banks fall short on their priority sector loans, they are permitted to buy these loans from NBFCs.

Tweaking the relationship with customers

What this co-origination will actually do is to create a partnership between the bank, NBFC and the borrower. Today, the business happens in a very informal way. For example, the banks lend to the NBFC and the NBFCs in turn keep a spread and on-lend to the small borrowers. Alternatively, such loans are given by the NBFCs and then they are securitized with the banks. Both of them become an arm’s length relationship and that can be converted into a partnership by aligning them into co-origination. Consider these statistics. According to data available with the RBI, priority sector loans by banks stood at nearly Rs 25 lakh crore as on June 30, 2018, up 6.3 percent year-on-year. Credit to NBFCs rose 35 percent year-on-year and stood at Rs 4.6 lakh crore in the same period. This entire cycle can be compressed into a simple partnership which can be achieved by letting banks and NBFCs actually co-originate loans.

How this entire exercise makes a difference to the profitability and valuations of banks and NBFCs remains to be seen.